By Derek Moore
After a respite yesterday, volatility came surging back this morning as the markets once again sold off. This leg down along with the rise in implied volatility provided an opportunity to enter a new position utilizing short put spreads going out to September 6th.
We’ve previously referenced the importance of option volatility when it comes to how far away the short strike of a HiPOS position can sit relative to the current market. Since we sell deep out of the money spreads, the further away the better. Off course we also need to have a position that provides the proper reward to risk metrics we seek.
With volatility spiking, we entered a short put spread trade that was about 19% below the current price of the underlying S&P 500 Index. This is a further distance than we’ve see recently and is a direct result of an increase in market volatility. The benefit of being farther away is that the position has more room for the market to move before it negatively impacts the trade. Above you can see our typical HiPOS graph which shows the expiration date of September 6th or 21 trading days.
While the ZEGA trading team does not necessarily impart directional bias into the trades, an expanded graph below illustrates that the short leg of the put spread sits below the old December lows. Putting on my technical analyst hat for a second, remember that old lows can be strong support areas where a stock or market may have difficulty breaking through.
One other note around the current trade; when we sell short put spreads we are short volatility. This means that an increase in implied volatility levels would be a negative for the position while a drop in implied volatility would be positive. Waiting to pick our spots let us establish the trade at a higher volatility level giving us additional cushion.
Now for the Particulars
- Index: S&P 500 Index
- Position type: Short Vertical Put Spread
- Short strike: 2300
- Long strike: 2250
- Risk (prob. ITM): <1% at time of entry
- Targeted return: 1.1%
- Distance OTM: ~19% at time of entry
- Expiration: September 6th or 21 trading days